Tim Olson
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description, tags
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| Rotates into sector ETFs with the highest Jensen's alpha estimated from a Fama-French factor regression, replacing raw cumulative return momentum with factor-adjusted alpha as the ranking signal. |
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Alpha Rotation
Section: 4.2 | Asset Class: ETFs | Type: Momentum / Factor-Adjusted Rotation
Overview
Alpha rotation is structurally the same as the sector momentum rotation strategy (Section 4.1), but replaces cumulative ETF returns R_i^cum with ETF alphas alpha_i. These alphas are the Jensen's alpha regression coefficients from a serial regression of each ETF's returns on the Fama-French factors, representing the ETF's return unexplained by common risk factors.
Construction / Signal
Run a serial regression of ETF returns R_i(t) on the 3 Fama-French factors (MKT, SMB, HML):
R_i(t) = alpha_i + beta_{1,i} MKT(t) + beta_{2,i} SMB(t) + beta_{3,i} HML(t) + epsilon_i(t) (364)
The regression coefficient alpha_i (Jensen's alpha) corresponds to the intercept and measures the ETF's risk-adjusted excess return relative to the Fama-French model. This alpha replaces R_i^cum as the ranking criterion.
ETFs are ranked by alpha_i (descending). Buy top-decile ETFs (highest alpha) and optionally short bottom-decile ETFs (lowest/most-negative alpha).
Entry / Exit Rules
- Entry: At rebalance, estimate alpha for each ETF over the estimation period; rank and enter positions in top-decile (long) and optionally bottom-decile (short).
- Exit: Hold for the standard holding period; rebalance at next scheduled interval.
- Estimation period: Typically 1 year; returns
R_i(t)are daily or weekly.
Key Parameters
- Factor model: 3 Fama-French factors (MKT, SMB, HML); note alpha here is Jensen's alpha for ETF returns, not mutual fund alpha
- Estimation period: Typically 1 year
- Return frequency for regression: Daily or weekly
R_i(t) - Holding period: Same as sector momentum rotation (1–3 months)
- Ranking criterion:
alpha_i(intercept of Fama-French regression)
Variations
- 4-factor model: Add Carhart momentum factor MOM(t) to regression for a 4-factor alpha
- R-squared augmentation: Combine alpha ranking with R-squared selectivity measure (see Section 4.3)
- Long-only: Buy only top-decile ETFs by alpha
Notes
- Estimation period is typically 1 year with daily or weekly return data.
- Jensen's alpha here is defined for ETF returns (not mutual fund returns as in Jensen, 1968).
- Alpha rotation is analytically cleaner than raw momentum rotation as it removes systematic factor exposures from the ranking signal.
- The MA filter and dual-momentum variations from Section 4.1.1 and 4.1.2 can also be applied here.
- Can be combined with R-squared (Section 4.3) to further refine ETF selection.